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Free Isn’t Free for Apple Investors, and Other Lessons From This Quarter’s Results

Aaron Pressman

The Exchange•October 29, 2013

Tim Cook

Apple (AAPL) shareholders can look forward to another strong holiday season after the company revamped almost all its leading product lines heading into the busiest shopping time of the year.

The final quarter comes after a mediocre fiscal fourth quarter (or what the rest of us call the third calendar quarter) for Apple. On Monday after market close, Apple reported its sales rose 4% to $37.5 billion and earnings per share slipped 5% to $8.26. But there were some important details revealed by Apple executives during their call with analysts after the report.

Free isn’t free for shareholders

Apple’s customers will be glad to get software updates and other apps free but shareholders will take a hit. Under U.S. accounting rules, giving away software with device purchases means Apple cannot report all the revenue from those sales immediately. For the final quarter of 2013, for example, the new freebies mean Apple must defer about $900 million of revenue to future quarters. That’s revenue that would otherwise flow straight to the bottom line, so the deferrals mean lower profits and a lower profit margin, too.

That’s not to say Apple made a mistake. Making its productivity suite free with the purchase of new devices helps put pressure on Microsoft (MSFT), which has yet to offer its Office apps for the iPad. It also matches free offerings from Google (GOOG) on the Web. And eventually the revenue will be counted.

The deferral also helped explain why Apple’s guidance about its gross profit margin for the current quarter of 36.5% to 37.5% was lower than analysts had expected. Backing out the deferrals, the margin would be more like 38% to 39%, in line with expectations. Apple shares initially sold off about 2% when it first reported the guidance. But once executives explained the reason on a call with analysts, the shares recovered.

iPhone line clicking without an extremely low-priced offering

This year Apple gussied up the middle of its iPhone line with the colorful 5C instead of just sliding down the old #1, the iPhone 5, into that spot. But it didn’t change its relatively high-end pricing strategy at all.

That had some investors worried but Tim Cook disclosed that all is well – each of Apple’s three tiers of iPhones, from the top-of-the-line 5S to the 5C to the old 4S, sold more in the past quarter than each tier sold in the same quarter a year ago. “We do need growth and we’re happy that we’ve seen that,” Cook said on the analyst call.

Cook is betting there are still plenty more premium customers wanting to buy iPhones, particularly in China. Offering a cheap phone now would risk cannibalizing sales of the high-end iPhones. Still some buyers can’t afford any of the current models – their demand for iPhones is what Tim Cook and economists call elastic, meaning it depends on the price. They’ll just have to wait, Cook said. “We understand there is elasticity in that market and we’ll move accordingly.”

Apple may again have supply shortages

One of the most disappointing aspects of Apple’s last quarter of 2012 for investors was that the company could have sold a lot more products than it did. Supply constraints limited sales of iPhones, iMacs and iPads. But, hey, they had plenty of iPods.

Again in 2013, Apple crammed almost all its new product introductions into the final quarter, and supplies could again be an issue. Cook said Apple still had a “very significant backlog” of orders for the iPhone 5S, though the situation was improving every week. That hot new iPad mini with the high-resolution “retina” display? “It’s unclear whether we will have enough,” was all Cook would say. “We’ll have to see how that goes.” As to new laptops and iMac computers, Cook sounded more upbeat, at least compared to last year.

Shareholders will be eager to learn how the story turned out. They’ll have to wait until January to hear from Cook & Co. again.

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